The importance of the discount
rate
Those issues that were treated at the conference
were issues involving widely different time scales. The costs of the
AIDS epidemic may be met now, whereas most of the costs of climate
change need only be met in 100 years´ time or more.
There is no unequivocal method to evaluate what is
more important, a cost now or another cost in a far future.
Nevertheless, economists try to do this, by using a tool called
discounting. Let us take the estimate (made with the RICE model by
Nordhaus & Boyer) that the total costs of climate change up to 2100
would correspond to a one-off expenditure of 650 trillion dollars (in
present-day prices). We could in principle invest a sum of money in a
"climate fund". If the amount invested grows at 5 % compound interest,
then it would suffice today to reserve 5 trillion dollars, because with
this rate of interest, this amount will have grown to 650 trillion
dollars in 2100. Economists therefore discuss the "present value"
of the costs of climate change to be defrayed in 100 years from now,
and with a 5 % discount rate this present value is 5 trillion dollars.
Thus, if different future costs are all discounted
to obtain a "present value", then they may be directly compared, even
though the costs will arise at different times in the future. And this
is the kind of comparisons that were made in the Copenhagen Consensus
conference.
However, the relative importance of different
expenditures defrayed at different points in time depend very much on
the discount rate used in the calculations.
This is illustrated by the following example. The
exact figures are not important: they are just made up to illustrate
the general point. Let us imagine that the AIDS epidemic, if not
combated, will necessitate the spending of 10 billion dollars in 10
years´ time, and that climate change, if not combated, will
necessitate the spending of 100 billion dollars in 100 years´
time.
To compare the costs, we discount the 10
billion dollars with a rate of 5 % over 10 years. This gives a sum of
6.1 billion dollars to be invested today in the AIDS fund, because this
will grow to 10 billion dollars in 10 years. And the sum to be invested
as a climate fund today will have to be 0.74 billion dollars, because
this will grow to 100 billion dollars in 100 years. The conclusion is
that the AIDS epidemic will be the more costly to us, and therefore it
will be wiser to fight AIDS, rather than to fight climate change. This
can be illustrated as follows:

5 % discount
rate

Amount now

In 10 years

In 100 years

Priority

AIDS fund

$6.1 billion

$10 billion

Higher

Climate fund

$0.74 billion

$100 billion

Next, we do the same comparison with a 1 % discount
rate. This time we find that we have to place 9 billion dollars in the
AIDS fund, and 37 billion dollars in the climate fund. So climate
change has now become the largest expenditure, and consequently, we
will choose to fight climate change rather than AIDS.

1 % discount
rate

Amount now

In 10 years

In 100 years

Priority

AIDS fund

$9 billion

$10 billion

Climate fund

$37 billion

$100 billion

Higher

So when we lower the discount rate, two things will
happen. First, future costs appear larger. Second, and more
importantly, the order of priority is reversed. With a 5 % discount
rate, AIDS is the more important, but with a 1 % discount rate, climate
change is the more important. The rate applied is subjective. In
choosing the rate to aplly you effectively choose the end result - and
can therefore choose which issue appears to be the more important. The
whole procedure becomes a trick.
This is probably the most important reason why it is
not generally advisable to analyse with the aid of discounting, when
issues to be compared appear at different time scales (unless one
provides unequivocal reasons for choosing one particular discount
rate).

To read more detailed
explanations on discount rates and what they mean, proceed tothis page.

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